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Jeffrey rosenberg, managing director, is BlackRocks Chief Investment Strategist for Fixed Income
Overweight Overweight Bank Loans Securitized Overweight Assets* Agency mortgages Corporates Non-US dollar Emerging markets Underweight Neutral Neutral Overweight
Wont get Fooled againand more of my Favorite Theme (songs) for 2013
This years outlook piece of greatest hits summarizes the investment outlook for 2013. Our lead theme highlights the short and long run aspects of the interest rate outlook. Over the long run, todays low interest rates lock in negative returns after inflation, fooling investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of fiscal policy uncertainty and economic resilience. Having achieved the last minute deal to avoid the worst case scenario, the fiscal cliff outcome postpones most of the difficult decisions into the debt ceiling debate. Whether those outcomes derail the economic recovery will determine whether rates end up higher or lower by years end and whether our expectations for modest increases in interest rates in 2013 targeting 2.25% for the 10 yearmeans we end up fooled again. Figure 1 summarizes our greatest hits of investment themes for 2013.
Turning Japanese
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And while we readily acknowledge that such a shift increases the amount of equity risk present in the fixed income portfolio, as we highlighted earlier, most typical core managers are already utilizing such a strategy so that most old era allocations already exhibit more equity correlation than they have in the past. Allocating away from these traditional strategies towards one of explicit asset allocation can better manage the equity risk lurking in the fixed income portfolio. As we detail more below, in increasing credit risk exposures, consider floating rate bank loans as a diversifier from high yield strategies that have worked well in the past but show more limited prospects in 2013. Consider adding emerging market alternatives and not just in sovereigns but corporate exposures as well. And consider flexible fixed incomebut where the strategy has ability to better manage those risks through its flexible approach and broader risk mitigation tool kit. Such flexible, unconstrained, or opportunistic strategies manage the credit and interest rate risks with management styles that are not tied to the benchmark or to the past strategies that increasingly wont work in tomorrows fixed income environment.
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adJusTing duraTiOn/yield mismaTcH Reduce Duration | Floating Rate, Long/Short, Flexible/Strategic Increase yield | High yield, Floating Rate, Flexible/Strategic
Interest Rate Risk Credit Risk
2 Precisely, under unchanged interest rate scenario, the aggregate index returns approximately 1.75%, 25 basis points below our expectation for 2% realized inflation in 2013, leading to a 25 basis point loss after inflation.
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ceiling debate along with the host of uncertainties will mean a considerable range in rates potentially as large as 50 basis points on either side of that 2.25% forecast. Continued Fed policy accommodation likely limits the scope for more increases than that in 2013. However, were policymakers to fail to come to an agreement on the postponed spending cuts necessary to strike agreement on raising the debt ceiling, it is likely that interest rates would remain low for longer amid the extended economic uncertainty. On the other hand, the outlook for inflation appears more clearly benign, excluding the volatile food and energy components. We expect inflation will hold steady at least for now given the lack of wage and benefit pressures and the subdued growth environment. Ultimately, we believe the fiscal policy negotiations will be conducted without permanently damaging near term economic confidence but remain doubtful on meaningful fiscal policy reform to address the long run issues, leaving our base case as 2% economic growth but with risks to the upside. Combined with the reduction in risks of eurozone breakup and a China economic hard landing, the flightto-safety into Treasuries should subside in 2013, leading to our view of modest increases in interest rates. However, amid the continuing subpar recovery and weak job market, the Federal Reserve will maintain its latest form of open ended quantitative easing that supports financial market asset inflation and continued low interest rates. Finally, we highlight the risk to our outlook for modestly increasing rates. For the past several years, expectations for rising rates have been dashed as external risks led to heightened economic uncertainty, increased demand for Treasuries, and more Federal Reserve bond buying. To be sure, our forecast for higher rates in 2013 is more modest than in the past reflecting these concerns. yet rates could end up even lower in 2013 under the alternative scenarios of self-inflicted fiscal policy damage, or if yet another bout of external risk whether from Europe, the middle or Far East or other hotspots were to again arise.
Figure 4: mind THe gap? relaTiOnsHip BeTWeen raTes and FundamenTals Breaks dOWn in a Qe WOrld
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towards signaling rising rates on any perceived temporary economic strengthening. On the other hand, it is aggressive at meeting expectations for ever-increasing amounts of policy accommodation. This policy reaction has led to a one-way correlation between rates and fundamentals: lower growth associated with declining rates but more limited increases in rates from higher growth. Similar to this time last year, the gap between low rates and rising economic growth suggests higher rates, yet persistent policy accommodation in effect soft financial repression holds down those increases. The prospects for a meaningful shift in housing (as we detail below), and more caution from the Fed from furthering unconventional policy at todays balance sheet size, suggests that 2013 could see an important shift in the prospects of future policysignaling moving the US ever so gradually towards easing off the accommodation. The limits of a still highly leveraged economy (let alone a highly levered government sector) limit the scope of any such increases, and hence our forecast for modest increases in rates in 2013. On the risk side stands the prospect that yet again economic growth that appears to be strengthening at the end of one year only to disappoint in the beginning of the next. This years disappointment may yet lie in the fiscal debate just past as the impact of the expiring payroll tax provisions plus continued fiscal uncertainty raise the risk of dampening spending from both declining disposable income as well as declining confidence. Those scenarios remain a risk to our otherwise constructive outlook on gradual yet modest
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stability in US economic growth leading to modest increases in interest rates over the course of the year.
These offer yields at more compelling valuations than typical high yield bonds. Overall, while likely generating lower returns in 2013, the high yield, loan and secured bond asset classes still offer attractive yields in the context of ample global liquidity that keeps default risk at bay in 2013.
Source: BlackRock.
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willingness and ability to borrow against the rising value of the asset. Credit fueled bubbles are strongly reinforcing until they ultimately collapse under the weight of their own debt. In broad terms, such a scenario characterized the lead up to the housing market fueled credit crisis of 2008. One key feature of that pre-crisis environment encouraging the use of leverage was monetary policy. In its response to the crash of the previous bubble the tech stock bubble the Fed first cut interest rates aggressively in 2001, then held the policy rate below the level of inflation from 2002 through 2005. Low interest rates create an incentive to borrow, but the size of the incentive is related to inflation: when inflation is higher than your interest rate inflation effectively helps to pay off the debt. Todays policy environment of negative real interest rates resembles that prior environment of 2002 to 2005 only
but the amount of money creation its rate of change, the length of time it will be being created and the creative forms in which its fact or promise takes place (the LTRO, the OmT, the FLS, etc)*that determines financial market prices much more than the performance of the economy. The risk, of course, is to mistake the recovery in financial market prices for signaling the success of these policy interventions in the real economy and forget the distortions such financial market behavior can have on the real economy through the allocation of credit and the pricing of risk. In todays unconventional monetary policy world, its the impact of the economy on monetary policy rather than the other way round that determines asset prices. And in the lyrics of the song, But its the laughter, that we remember, when we remember, the way we were.
movin Out
Of the basement, that is; representing our housing recovery theme and a great source of optimism to the economic outlook in 2013. Of the key changes in the macro outlook for 2013, a definitive turn in the housing market stands as one of the most important potential reasons to expect better than expected growth in 2013. Housing and its collapse stood at the root of both the crisis and the slow growth aftermath going on over four years. And the failure of the Feds reflation policy as described above to migrate successfully into the housing market accounts for both the continued tepid recovery and the robust monetary policy response up to todays unlimited promise of money creation termed QE infinity.
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its gone global. Today every single major developed central bank runs negative real interest rates. And unlike in 2010 and 2011, in 2012 and 2013 emerging markets are also running more accommodative policy as opposed to tightening policy making the currency outlook more ambiguous than in prior periods of Fed quantitative easing. Together, this global policy accommodation fuels inflation of a different sort, inflation in asset prices. That feature explains the disconnect between financial asset price performance where US stocks increased double digits and risky portions of fixed income such as High yield returned nearly 16% while the economy barely grew above 2%. In a world of massive money creation from global central banks, the fundamental driver of asset prices is not fundamentals
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Source: Bloomberg. Note Banks represented by KBW Bank index; Homebuilders by S&P 500 Homebuilding Index.
* LTRO - Long-Term Refinancing Operations; OMT Outright Monetary Transactions; FLS Funding for Lending Scheme
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To what end? To the recovery in the job market before fueling inflation hopes the Fed. The slow road to that recovery went through the inability of the mortgage market to transmit the policy accommodation into the housing market: unintended policy actions restrained the growth of credit while persistent weak hiring from a lack of business confidence restrained demand as the kids in the basement delayed household formation due to want of a job. Now it appears all of that may be about to change to the benefit of better than expected economic growth. While we share these views, the trouble is so too does everyone else. Housing recovery-themed investment strategies already outperformed last year. With so much hope for such a recovery priced into the market, the risk is disappointment in 2013, particularly in homebuilder stocks. However, other beneficiaries exist including bank bonds in the investment grade market and credit areas of the mortgage market though admittedly with more limited upside than last year given current prices. going further down the capital structure in banks also makes sense as bank equities have significantly lagged other housing recovery themed sectors (e.g. homebuilders as indicated in Figure 8) suggesting banks can outperform homebuilders in 2013.
of an economy, especially one in which the share of manufacturing is nearly 50%. Figure 9 shows the Li Keqiang Index relative to official gdP. given this index doesnt capture much in service sectors, it is more volatile than gdP growth. As we can see, starting from beginning of 2012, the index started a broad decline before it rebounded in fourth quarter, helped by increase in fixed investment and easing monetary policy. These two policy levers represent the traditional policy accommodation levers used by China policy makers to stimulate (and restrain) the economy. Little by way of transformational policy has been accomplished in that most of the economy is still heavily geared towards production, investment and exports and a strikingly low (by historical and geographical comparison) level of domestic consumption. Figure 9 highlights that these traditional policy levers suggest better economic performance from China in 2013.
Longer term, the ability to sustain this level of growth hinges on the adoption and successful implementation of critical structural reforms. For example, according to the China Institute for Reform and development, rising rates of urbanization could account for increasing consumption share of gdP from current levels around 35-40% to 55% over the next decade. Chinas successful transition to a consumptiondriven economy hinges on Chinas ongoing reforms in the resident registration system, the financial system (interest rate liberalization, exchange rate liberalization and financial market liberalization), and factor price liberalization (removing price controls both subsidies and caps). Key to monitoring progress along these lines will be the National Peoples Congress and Consultative conferences in march and the 3rd Plenary
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session of the 18th Party Congress in the Fall of 2013. For the short term, well watch both the official sector data and Li Keqiangs recommended sectors to answer How will I know?
Turning Japanese
NIKKEI INDEX
Or should we say Turning Bernankese? Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013, however, we would look for some pullback in the first quarter. While we would be cautious about extrapolating too much of the 2012 surprise story into 2013, the broader implications of a scenario of Japan reflation need to be considered for the outlook in 2013. For much of the past 20 years, global growth prospects have been held back by the lost decades in Japan: real growth rates that barely notched above 2%. Lost in the focus of developed market growth difficulties in the US and eurozone and emerging market growth optimism stands the lack of Japanese growth. There is a dichotomy between the share Japan represents of the world economy (just under 10%) and its share of the worlds economic growth (negative in 2011). Even a modest shift in Japan growth from more aggressive monetary policy holds the prospect for upside surprise in global growth in 2013. Whether the incoming Abe administration and the potential changes can meet the markets expectations for currency
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weakness and reflationary domestic monetary policy remains to be seen. To be sure, prior bouts of Japan optimism have been met with disappointment. However, taking a page out of the other developed central bank policies of massive money creation suggests a more significant expansionary monetary policy in Japan may be on its way along with a contribution to global liquidity and asset inflation that the Fed and the ECB so far have led.
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The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (high yield or junk bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
The opinions expressed are those of BlackRock as of January 11, 2013, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader. FOR MORE INFORMATION: www.blackrock.com 2013 BlackRock, Inc. All Rights Reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and SO WHAT DO I DO WITH MY MONEY are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. Prepared by BlackRock Investments, LLC, member FINRA. Not FDIC Insured May Lose Value No Bank Guarantee Lit. No. ISG-0113 AC6470-0113 / USR-1354